Nepal - Power sector development strategy

Report No. 21912-NEP Nepal Proposed Power Sector Development Stirategy March 19, 2001 Energy Sector Unit South Asia Regional Office Document of the World Bank .: I .L "4m  ABIREVIATIONS AND ACRONYMS ADB = Asian Development Bank CEPA = Corsolidated Electric Power Asia CERC = Central Eectricity Regultory Commisson DANIDA Danish Intenafional Deveopment Assisnce DOED tDepatmt of Electricity Development EIA Environmental Impact Assessment EMS Enegy M anae t Systems EPC = Environmnt Protecton Council ESAP - Enery Sector Asionce Progm ESMAP = Energy Soctor Management Assistance Progrnmme ETFC Electricity Taiff Fixation Commission GOI Govemment of India GTZ Deutsche Gesellschaft fur Technische Zusamnm_eit GWh Gigawatt Hour HMGN = His Majesty's Government of Nepal HVPN Hana Vidyut Prsan Nigam Limited iFC = International Finance Corporation IPP = Independent Power Producer ISO Independent System Operator fW - Kreditanlt fur Wiederaufbau kV Kilovolt KW = Kilowatt LDC = Load Dispatch Center LNG 5 Liquefied Natural Gas MOPE Ministry of Population and Environment MOWR = Ministry of Water Resources NDC = National Development Council NEA = Nepal Electricity Authority NGENCO = Nepal Hydropower Generation Company NGO - Non-Governmental Organization NPC = National PInuing Commission NTPC = National Thermal Power Corporation o & M = Operation and Maintenance PLF Plant Load Factor PPA = Power Purhase Agreement R & R = Resettlement and Rehabilitation RLDC = Regional Load Dispatch Center RMB = Regional Maement Board ROR = Run-of-River S & MO = System and Market Operator SLDC State Load Dispatch Center T & D = Transmission & Distribution TFC = Tariff Fixation Committee USAID = United States Agency for International Development WCD = World Commission on Dums WECS Water and Energy Commission Secretariat WRC = Water Resources Council WRDC = Water Resources Development Council Vice President: Mieko Nishimizu Country Director: Kenichi Ohashi Sector Director: Alastair J. McKechnie Team Leader: Tjaarda P. Storm van Leeuwen Task Leader: Mudasr Imran  Abstract A major policy objective of the Government of Nepal is to develop the nation's vast hydro power resource potential to serve the electricity needs of the people, and to generate export revenue. While over the past years progress has been made in developing regulations and policies to attract investments for hydropower development, institutional constraints pose a challenge to implementation. This report attempts to analyze the key implementation constraints facing Nepal's hydropower development, and proposes options for reform. The rationale for reform is embedded in the realization that the investment needs of the power sector are growing much faster than the financing capacity of the Government of Nepal, at a time when the availability of concessional multi- and bilateral resources for infrastructure investments is declining. The report notes that among the key constraints the four most prominent ones inclwde: (i) overlaps in the policy, regulatory, and operational functions of public institutions operating in the electricity sector; (i) inadequacies of the existing institutional structure of the National Electricity Authority to meet future needs of the power sector; (iii) insufficient institutional arrangements for the promotion of power trade; and (iv) weak institutional support for improving electricity access to rural areas. The report makes the following recommendations in the four areas listed * The role ofpolicy making should rest with the Ministry of Water Resources, with the possibility of the Department of Electricity Development and the Water and Energy Commission Secretariat given the role of executing bodies. The Electricity Tariff Fixation Committee should be redefined and over time be allowed to evolve into an independent regulatory authority. * While there are alternative institutional restructuring options for the Naiional Electricity Authority, certain common principles apply for private capital to be successfully mobilized. These include: eliminating conflicts of interest; improving creditworthi,ness; improving opportunities for attracting private capital; and providing appropriate regulatory framework for the operation of the system and technical and commercial rules for grid operation. Reconstitution of the board of directors of National Electricity Authority with a private professional board could be a useful transition arrangement. * Nepal's comparative advantage in hydropower lies not as much in the cost of dleveloping hydro projects as it does in the fact that it is unencumbered by the complex Centre-State relationships, and inter-state water disputes that characterize the Indian situation. The Government of Nepal has an opportunity to create a policy environment for independent power producers that is more favorable than in India for the development of medium sized dedicated export projects by the private sector. * To improve electricity access to rural areas, Nepal must supplement exisring institutional methods of delivering electricity services to rural areas with innovative appro,ches, such as by developing community based systems. Rural electrification business must befinancially viable for it to succeed. Efforts are needed to establish rules that allow cost recovery and possible mechanisms for providing subsidies for capital costs of new connections.   CONTENTS Page No. Executive Summary ................................................. i . Introduction .1 II. Overview of Nepal's Power Sector .2 Supplies and Resource Base .2 Demand and Prices .3 Market Balance .8 III. Main Issues and Challenges ..............................................9 The Need for Investment ......................................... 9 The Challenge .......................................... 10 IV. The Roles and Responsibilities of Public Sector Institutions ..1............................................ 1 Need for Introducing Institutional and Structural Changes ......................................... 11 Streamlining Policy Making Bodies .12 Rationalize Planning .12 Separate Regulation from Policy .13 Improve Climate for Mobilizing Private CapitaL .14 Action Plan .15 V. Institutional Restructuring of NEA ..15 Rationale for NEA Restructuring .15 Restructuring Options for NEA .16 Possible Issues Related to the Restructuring Options .17 Potential Benefits of Restructuring .19 Action Plan During the Transition Period .19 VI. Power Trade ................................................. 20 The Market for Exports ............................................ 20 Constraints on the Indian Market ............................................ 21 Recent Developments in India - Improving Prospects for Trade ............................................ 22 Options for Increasing Power Trade ............................................ 24 Economic Benefits of Power Trade ............................................ 24 Action Plan ............................................ 25  VII. Rural Access to Electricity .......................................................... 26 The Challenge .......................................................... 28 Options for Improving Rural Access .......................................................... 28 Subsidies - Reaching the Poor .......................................................... 3 1 Establishing User Groups and Promoting Awareness Campaigns ......................................... 32 Action Plan .......................................................... 32 Annex 1: Hydropower Development Policy (2056) - Comments .................................................. 34 Annex 2: Existing Institutional Arrangements .......................................................... 41 Annex 3: The Inefficiencies in the NEA System .......................................................... 43 Annex 4 Chronology of Power Sector Reformn in selected countries/states ....................................... 44 Annex 5: Franework for Electricity Trading in India .......................................................... 49 Annex 6: Market Prospects for India - Alternative State Power Reform Scenarios .......................... 52 Bibliography ......................................................... 56 This report has been prepared by Mmes. and Messrs.: Mudassar Imran (Task Leader), Tjaarda P. Storm van Leeuwen (Nepal Team Leader, and Lead Financial Analyst), Peter Meier (Consultant), Mangesh Hoskote (Senior Power Sector Specialist), Beatrice Arizu (Consultant) and Enno Heijndermans (Senior Alternative Energy Expert), with inputs from Magdalena Manzo (Senior Operations Officer), Douglas Bames (Energy Planner), Surendra Govinda Joshi (Transportation Specialist), Rajendra Dhoj Joshi (Senior Education Specialist), Barry Trambath (EASEG), John Kuiper (Asian Development Bank) and Dow Nichol (Consultant, Intemational Resource Group). Valuable assistance has been provided by Mines. Vikki Ziff (Projects Assistant), Thelma Rutledge (Team Assistant), Johana Thapa (Team Assistant) and Marcia Whiskey (Program Assistant). The authors greatly benefited from comments provided by the Government of Nepal, from the participants of Technical Discussions Meeting held in Katmandu from February 28-29, 2000 and from the Quality Enhancement Group Review chaired by Mr. Yoshihiko Sumi, and several other reviewers, including Messrs. Hans M. Rothenbilhler, Country Director Nepal (former); Kenichi Ohashi, Country Director, Nepal, Alastair J. McKechnie, Sector Director South Asia Energy Unit; Sadiq Ahmed, Chief Economist SAR; and Asif Faiz, Operations Advisor SAR. The updated version of the report was extensively discussed by a team of Bank staff including the Sector Director South Asia Energy Unit, Operations Advisor, and the Task Leader with HMGN, international donor and the NGO community in Katmandu over the period December 4 - 8, 2000. The HMGN accepted the report with minor corrections, which are incorporated in this Final version.  Executive Summary Introduction 1. Despite having an estimated hydropower generating potential of about 43,000 megawatts (MW), Nepal's current total installed generating capacity is only about 319 MW (in 1999)1 and its per-capita electricity consumption of about 42 kWh is amongst the lowest in the world. Only about 15 percent of the population have access to electricity. In rural areas where the bulk of the population resides (88 percent), access is even lower (5 percent), partly as a result of a higher priority given to providing power to high-density urban areas. The quality of supply is poor; systems losses are high; power shortages are persistent; and outages are frequent. Power trade with neighboring India is minimal, and Nepal has been a net importer of power from India over the past few years. Cost of electricity in Nepal is one of the highest in South Asia and has now reached the limits of affordability for a vast majority of the population. 2. Recognizing the need to address these issues and to develop its water resource potential, HMGN has made the development of Nepal's hydro-electric potential to serve the energy needs of its people and for export, one of it's key developmental objectives. This objective is articulated in the Ninth Five-Year Plan document (1997-2002), and in the Water Resources Development Strategy paper. The emphasis on power development follows the adoption of the Hydropower Development Policy in the early 1990s which, combined with changes in electricity legislation and the opening up of the power sector to local and foreign private investments, was intended to make institutions operating in the power sector efficient and creditworthy, as well as increase the participation of the private sector. While under this policy and regulatory framework HMGN has been able to attract some private (foreign) investments in power generation, NEA is still neither sufficiently efficient nor creditworthy; and the trade-offs between water and power use have only recently been considered as part of the comprehensive Water Resources Strategy. Experience over the last few years has shown a lack of transparency in project planning and selection; absence of competition; growing conflicts of interest between private entities involved in the sector and NEA (which is a buyer and a joint-venture partner in NEA power generation projects); and increasing frustration about the inability to mobilize further private and public capital to exploit Nepal's water resources potential. 3. In order to address the fundamental issues facing power development, particularly in light of efforts to attract foreign investment, HMGN is in the process of developing a Hydropower Development Policy, the most recent draft of which was circulated in December 2000. While the hydropower policy is still evolving, the latest version highlights a number of significant changes. The new policy: advocates a new institutional structure, more clearly separating regulatory and promotional functions; provides greater clarity in the commitment of HMGN to general institutional reform, including unbundling and private investment in distribution; gives a more detailed enumeration of the royalty structure; provides a more detailed exposition of the rules for repatriation of equity returns for projects involving foreign investors; and gives more explicit consideration to the role of hydropower in rural electrification. 4. However, in some critical areas the proposed new policy is either unclear or does not go far enough. For example, while the policy advocates transparency in the award of licenses, it does not enumerate the criteria upon which the license would be awarded. Furthermore, the policy is unclear about the milestones which a developer is expected to have achieved before a production license is awarded (such as a signed and bankable power purchase agreement, financial closure). Nonetheless, the issuance of a new policy is appropriate and timely; and while implementation of the recommenclations pose serious challenges, the policy is a significant step forward in addressing some of the issues facing power 1. Installed capacity is estimated to have reached 378 MW in 2000, because of the coming on stream ofi Kimti Kola and Modi Kola during the second half of 2000 (Source: NEA's- Corporate Development Plan, FY2000/01-FY2004/C5, December 2000)  -II- development in Nepal. However, Nepal's ability to develop hydro power projects for export depend also on developments in the Indian electricity market over which Nepal has no control. The Challenges 5. Although precise estimates are difficult to make, taking into account even the conservative estimates for projected growth in demand for electricity, the financial resources required for the expansion of the power sector for domestic market alone over the next ten years are estimated at roughly US$1.8 billion. This vastly exceeds the availability of funding from the traditional multilateral and bilateral agencies. (Adding financing requirements for export oriented projects, the capital needs are even higher). Over the period 1991-98, NEA's capital expenditures totaled around US$730 million, of which roughly US$490 million was raised from loans and US$180 million in equity. Even if NEA manages to generate 25 percent of the sector's expected capital needs for the next ten years through internal cash generation, the balance of about US$1.3 billion will have to come from external sources in the form of loans or additional equity just to satisfy the needs of the domestic market. 6. The need for raising financing has now become even more important given the declining trend in the availability of concessional official resources for power sector development, and the recognition that scarce public resources are needed for the development of social sectors. Increasingly, therefore, investment resources for power development will need to be mobilized through the private sector. Even a public sector enterprise such as NEA will have to rely increasingly on internal resources and private capital markets, which requires NEA to be creditworthy. However, the policy to attract private investments should be based on market realities. Over the past few months, in an effort to increase direct foreign investments in power, the Government has invited private investors to develop selected hydro projects in Nepal. While this step has attracted private interest and several survey licenses are under consideration, it is not clear if this initiative is sustainable, especially in light of the difficulties hydro projects face in reaching financial closure. Factors such as financing terms (and their implications for tariffs), the creditworthiness of buyers, cost of alternatives and environmental impacts, must play an important role in deciding the location of sites, and the number and magnitude of contracts to be awarded for new power projects. Furthermore, given that clients in the Indian states at present are not creditworthy, lenders are likely to seek government guarantees, potentially creating contingent liabilities for the Government. A call on these guarantees could create major macro economic disruptions. Even if none of the projects reach financial closure, the effective 'property rights' gained by private developers to good hydro sites could prevent their development for an extended period of time. The long process of renegotiations without adequately addressing the fundamental policy and structural problems, run the danger of damaging private sector confidence in Nepal. 7. Thus, the primary challenge facing Nepal is to generate sufficient financial resources to expand its power supplies-based on market realities-in an environmentally sustainable and socially acceptable way to meet the needs of its people both in the rural and urban areas. Additionally, power supply expansion needs to be done in a least-cost way that makes power affordable to domestic users and allows Nepal exports to maintain a position of comparative cost advantage. The strategy to expand power supplies and access to these supplies by the majority of consumers is inevitably linked with the paramount goal of poverty reduction. The Strategy for the Future 8. While over the past years, progress has been made in developing regulations and policies to meet HMGN's developmental objectives for the power sector, further institutional changes are required to ensure their implementation. There are several areas where HMGN action is needed, the most important among them include: clarifying the roles and responsibilities of public sector institutions operating in the power sector; restructuring and privatizing NEA; promoting power trade with India; and improving rural access to electricity. These are briefly discussed below.  -iii- 9. Clarifying the Roles and Responsibilities of Public-Sector Institutions: Under the current institutional framework, there is no clear separation of policy, regulatory, and operational functions in the electricity sector. Furthermore, coordinating bodies designed to ensure consistent policy making between sectors are not functioning adequately. Collectively, there are about 14 institutions which, in combination with a multi-level approach, have led to conflicting roles and responsibilities. There are multiple institutions involved in policy formulation. The extent of overlap between the five main entities active in power, viz., Ministry of Water Resources, NEA, Electricity Development Center, (recently the name of this agency has been changed to the Department for Electricity Development), Water and Energy Commission and Electricity Tariff Fixation Committee, is evident from the fact that all five entities are involved in several similar activities such as systems planning; project identification; issuance of survey license; and multipurpose and export oriented projects. (Chart 1)2. These overlapping roles of public sector entities, and the resulting conflict of interests, have been sending confusing signals to the private sector and have constrained their involvement in Nepal's power development. Chart 1: Overlapping Roles of Power Sector Institutions 10. Many of these issues have been highlighted in the last few years, but rather than clarifying the role of existing entities or modifying existing policies and guidelines, the reaction has been to create new umbrella organizations or coordinating committees thereby compounding the problem. Clearly there is an urgent need for seeking a consensus among the agencies on their respective roles in sector development; planning, licensing and regulatory regimes; and water resource development for multipurpose and export projects. This would facilitate private sector investmnent in the power sector. Rationalization of government agency roles and responsibilities is also a fuindamental requirement to meel the Government's objectives of developing a new industry structure. It. Tht; following actions should be considered as soon as possible: (i) consolidate technical policy advice on water resources development into one entity and eliminate overlapping responsibilities within the Ministry of Water Resources; (ii) clarify responsibilities for monitoring and enforcing compliance with environmental legislation between the Ministry of Population and Enviromnment and the Ministry of Water Resources; (iii) rationalize planning fuinctions; (iv) finalize the comprehensive review of the Department for Electricity Development (Electricity Development Center) licensinig procedures and regulatory function of the Electricity Tariff Fixation Committee, and consider the establishiment of a 2. In few areas however, the functional role of institutions such as WECS is limited. For example, the role of WECS in project identification is limited only to inventory studies; and to the identification of small private hydro power projects. MOWrR sets the policy, and DOED is the executing body.  -iv- separate regulatory authority; (v) prioritize agreed institutional and policy changes and start implementation; (vi) accelerate creation of the Power Development Fund and initiate competitive bidding process for medium size hydropower projects; and (vii) finalize the preparation of the national water resource strategy and create national consensus on basin development. 12. Restructuring and Privatizing NEA: Though in the South Asian regional context NEA, as an integrated utility, has been performing better than many other publicly owned utilities, serious problems still persist: its operational efficiency is weak (transmission and distribution losses of the NEA system [technical and non-technical] are around 30 percent and in some areas are as high as 50 percent); its creditworthiness is insufficient to allow access to private capital markets; and there are growing conflicts of interest with existing and new independent power producers, some of which are joint ventures between private investors and NEA, and for which NEA is also the principal buyer. Furthermore, NEA, as the owner of the transmission and load dispatch system, has conflicts of interest with regard to opening-up grid access to private independent power producers, since NEA decides what independent power producers can and must do. There are examples around the world of integrated utilities operating at reasonable levels of efficiency; however, there are very few examples in developing countries demonstrating that integrated publicly owned utilities develop into efficiently operated entities with adequate access to private capital markets, and at the same time, resolve the conflict of interest issue, combined with a significant entry of private power producers in the market. Moreover, there is growing experience that an unbundled power supply system with significant private ownership in distribution, if appropriately regulated, would be able to provide over time much better service delivery at much lower cost. Therefore, developing NEA as an integrated publicly owned utility cannot be considered as an optimal solution. The need for restructuring NEA is clear, and the rationale for restructuring is grounded in the needs of the future, inter alia, mobilizing private capital necessary for the much larger future facilities contemplated by NEA's generation expansion plan (such as Upper Karnali and Arun). 13. Worldwide experience shows that there is no one formula that can be held up as a universal model. Each country has unique problems, resources, and institutions. There are several possible restructuring options NEA can adopt, some of which include: E internal reforms (in which NEA's functions are internally separated through creation of profit centres); * spinning off NEA's joint venture as separate companies; * unbundling generation, transmission, and distribution (along the lines of many countries in Latin America and India (Orissa and Andhra Pradesh), sometimes referred to as a single buyer or Independent Market Operator (IMO) model; * subsequent privatization of unbundled entities - again there are several options, ranging from outright sale to strategic investors, to joint ventures with minority Government participation (or with so-called "golden shares," an approach used in privatization of some public companies in the United Kingdom) and listing on the stock exchanges; * management contracts (although the South Asian experience has not been very successful, the results have been more positive in Africa and Latin America). 14. In more developed countries, the IMO model often evolves into a competitive Wholesale Market Model with competition introduced even at the retail level. For Nepal, the Wholesale Market Model could only become a realistic option in the distant future, once several new players have entered the market and creditworthiness is fully restored, implying several years of successful operation of unbundled distribution companies under the IMO model. Privatization of distribution and transparency in systems operating rules are key elements of the IMO model. 15. While there are several approaches to unbundle Nepal's power system, a possible option would be to differentiate entities by functions and responsibilities as follows: NEA would be reorganized into two  Integrated Generation and Distribution Companies (IGDs); one Distribution Company; one Generation Company; and one Transmission Company with the load dispatch center. Other variants are possible while maintaining the same principles and objectives and would need further study. The existing and alternative industry structure characterized as variants of the IMO Model are illustrated in Charts 2A & 2B below. An important feature of this variant of the IMO model is that it permits distribution companies to have generation (integrated-generation companies), and these companies can trade excess energy with other generators and distributors. It therefore does not involve a complete separation of the system into generation, transmission, and distribution companies, as typically implied by unbundling. The model and its suitability for Nepal are discussed in more detail in the background report.3 Chart 2A: Existing NEA Structure Chart 2B: IMO Model Nepal Electricity Authority Nepal Electricity Authority - Reorganized Organizational Structure Independent Market Operator Model NEA NEA ROR Hydro Stationl Hydro Storage Powe Stason _ Load Dispatch Centre IPhS ROR Hydro StfiJon NEA Transnsmicte Direnaote R iPPyroStahos a _ NEA Transmission and Substation Directorate Tlemml (,enoeetion nThermal GMnerabon Dir ct ra NEA Plannmg, Development, and West _ _ General Management DireCtDralte _1. Diditin NEA _ Dutfibution and Consume Services HoPower Foar PWenag i -o _ ___ _ Sa t _ dSevic _ 16. Whatever model of institutional reform is followed, there are certain principles that apply everywhere for private capital to be successfully mobilized, such as: eliminating conflicts of interest and leveling the playing field for private investors; an adequate regulatory system, and transparent systems operating rules. Reconstitution of the board of directors of NEA with a private professional board could be a useful transition arrangement, but unbundling without a significant shift towards pnrivate ownership is unlikely to achieve the desired efficiency gains and increase the access to private capital. However, before deciding on an exact configuration of the unbundled power sector most appropriate for Nepal, preparatory studies are required which would include, inter alia, definition of technical boundaries, allocation of assets, liabilities and personnel, transfer pricing, dispatch and system operating rules, wheeling arrangements etc. Options for phasing the unbundling by, for example, creating companies similar to the Butwal Power Company could be considered. 17. Promotine Power Trade with India: The potential market for power in India, particularly the Northern Grid Region-including Western Uttar Pradesh, and Delhi, which lies to Nepal's west-is large. The Indian Central Electricity Authority (CEA) has estimated a shortage of roughly 10,000 MW in the Northern Region at the end of the Tenth Five-Year Plan (2007). This region faces chronic power shortages that are likely to continue in the foreseeable future and could considerably benefit from power exports from Nepal. While the potential for exports is large, the very conditions that have led to the presently large shortages of power in India, namely the effectively bankrupt and commercially uncreditworthy financial condition of many Indian State Electricity Boards (SEBs), also constrain any large-scale absorption of Nepalese exports. Progress in Electricity Board reform in Orissa, Haryana and 3. Institutional restructuring of NEA, Mangesh Hoskote and Bearice Aizu, April 2000.  -vi- Andhra Pradesh, as well as in Uttar Pradesh, Rajasthan and Karnataka which are on the verge of reform, combined with several positive developments recently in India, would enhance the opportunities for Nepalese hydropower exports. These developments include the establishment of the Central Electricity Regulatory Commission; the creation of the Power Trading Corporation (PTC); the regional load dispatch centers operated by Powergrid; and the increasing integration of the regional grids through additional inter-tie capacity. However, these developments will also benefit Indian hydro schemes that are potential competitors to Nepalese export projects. Nonetheless, a healthy and financially viable Indian power sector would also benefit Nepal. The recent developments in India mentioned above improve the prospects for developing power pool trading arrangement into which Nepal could sell its output. Such pools may either be on a gross - where all power is sold through the pool-or net basis, where only power not already sold under physical bilateral contracts is traded. Successful pools however require, inter alia, mature and robust commercial environment and competitive electricity markets, under which individual generators compete for the dispatch of their plant outputs on a daily or hourly basis, a situation which is not likely to happen in South Asia for quite sometime in the future. 18. Nepal's comparative advantage in hydropower lies not in the cost of developing hydro projects, but mainly in its ability to create an institutional framework that would enable export oriented. hydro projects to be implemented more easily than in India, and less subject to delays due to inter-state water disputes and resettlement and rehabilitation controversies. Although the Arun precedent, and the existence of some 30,000 NGOs suggest that developing hydro projects in Nepal will face some difficulties, the fact that Nepal is a small country unencumbered by the complex Centre-State relationships that characterize the Indian polity, gives HMGN some advantages vis-A-vis India. These advantages can be maximized by creating a policy environment for independent power producers that is more favorable than in India. While important steps in this direction have already been taken, additional action is required to strengthen Nepal's potential advantage over India. 19. Large projects would benefit from economies of scale and lower costs. However, given the lack of creditworthy clients in India for the next several years, the rehabilitation and resettlement problems associated with larger projects, and the inherent difficulty with raising financing for large hydro projects, the best prospects for increasing hydro exports over the medium term are smaller, dedicated medium sized export projects whose output can be absorbed by creditworthy buyers. Such projects would still be difficult to implement since even under ideal conditions, hydro projects are more difficult to implement as independent power producers than thermal projects, but their prospects are materially better than for mega-hydroprojects. Focusing on medium and smaller dedicated export projects does not mean, however, that efforts to continue with the development of large storage hydro and multi-purpose projects should be abandoned completely. An important first step should be to explore new models of public- private partnerships to address the difficulties of attracting private financing for large projects. These options would require institutional reforms in the Nepal power sector and at a minimum separate hydro- generation company mandated to run on commercial lines. This company could initially be Govermnent owned but established in a suitable form for raising private capital through joint ventures and/or special purpose project companies. 20. In order to implement this hydropower export strategy, HMGN should consider taking several immediate actions as follows: * seek ratification of the Power Trade Agreement between India and Nepal which is still before Nepal's Parliament, and institute regular meetings of the Power Exchange Committee; * update the Masterplan to reflect recent developments in India; * study new market arrangements in India, and the market prospects for Nepalese power output in South Asia; * explore possibilities for sale of surplus energy during wet seasons to the Northern Indian grid;  -vii- * conduct a detailed engineering study to quantify the costs, benefits, and optimal timing of asynchronous links and grid integration with India; and * identify daily peaking run-of-river sites in the medium size range for potential private sector development as dedicated export projects. 21. Improving Rural Access to Electricity: Low access to electricity in Nepal has deprived the people of basic amenities of life and of opportunities for development. The lack of access to commercial energy forces rural consumers (comprising over 88 percent of the population in Nepal in 1996) to rely on traditional fuels, mainly fuelwood, agriculture waste, and animal dung for cooking andl lighting needs. Of the total residential energy consumption in rural areas, traditional fuels in 1995/96 accounted for over 98 percent of consumption (in urban areas the share of traditional fuels was just under 77 percent). The heavy reliance on tradition fuels poses serious threats to the health of the rural population, especially women and children who are most exposed to indoor pollution. 22. There is sufficient evidence on the positive impact access to electricity has on the lives of the poor. Studies in other countries show that having electricity is beneficial for children's education because it facilitates reading during the evening and in the early morning hours. Electricity also provides access to knowledge and information to people in rural areas via communication media such as television and radio that otherwise would not be possible. Depending on the conditions in local communities, electricity can also lead to increases in rural productivity by allowing work in the evening hours. EIlectricity programs often compliment health programs by providing refrigeration for medical supplies. Evidence from Peru shows that programs involving complimentary social infrastructure, including rural electrification, have a greater impact than any one type of infrastructure on its own. 23. The main challenge therefore, is to provide sustainable and affordable access to energy in the rural areas. The importance of meeting this challenge is articulated in the Ninth Plan, which documents HMGN's desire to improve the provision of electricity services to rural areas. While the provision of a full range of energy services (including access to petroleum products, together with improved cooking stoves with a chimney) should constitute the nation's rural energy policy, the focus of'discussions here is on rural electrification only. 24. There is no single technology that would best suit all possible applications and rural settings, and only a mix of different rural energy technologies can respond to the diverse site conditions and customer requirements. The optimal choice of rural energy technology varies depending on factors such as: site and location; distance between the rural load centre and the integrated Nepal power system (INPS); access to road; whether or not the electrification project is a greenfield development, and how much experience the rural community has with electrification projects; expectations about future industrial loads, lighting and entertainment needs; and harmony within the communities etc. 25. While the expansion of the national grid is an important rural electrification option, because of the difficult terrain and the low level of general electrification in Nepal this option alone will not solve the problem. In addition, the grid expansion would require an adherence to the principles of emerging best practices, including financial viability of the national entity, NEA, involved in developing rural distribution systems. At present, except for initiatives such as those by the Butval Power Company (BPT), grid-based rural electrification is the sole responsibility of NEA. The BPT is the only other non- NEA agency that has so far implemented grid-connected rural electrification, with relatively better success than NEA. It is not clear whether NEA is the most suitable agency to promote rural access. This is one area which warrants the active participation of the private, as well as the public sector. Other options for increasing electrification in rural areas include: * mini grids based on micro, small and medium hydro * mini grids based on diesel and photo voltaics  -viii- * battery charging stations connected to the grid or any of the above mini grids * solar home systems * wind * biomass Several international donor agencies are actively involved in a number of decentralized rural electrification schemes but the impact so far has been small. 26. Subsidies are clearly undesirable because of the many distortions they can create; their regressive nature; and the difficulties in removing them once their usefulness is outlived. Furthermore, there is ample evidence world wide that subsidies rarely reach the poor for whom they are intended. However, subsidies may be needed to promote rural electrification in Nepal as evidenced by examples from other countries. 27. In designing a subsidy scheme the following important questions must be carefully considered: whom to subsidize? If subsidies are meant to improve the welfare of the poor, they must be directed to the people who cannot afford access to high-quality energy services. These are typically the very poor, living in rural areas. What to subsidize? Evidence from other countries show that providing a partial subsidy on the cost of connections is more effective than a subsidy for ongoing energy charges. Capital subsidies on access costs not only reduce the cost of service to the poor; it also encourages businesses to increase connections in the rural areas. How to subsidize? Subsidy implementation mechanisms are broadly categorized as demand side subsidies and supply side subsidies. Although, in the context of Nepal further study is needed to establish the right mechanism, in general, demand side subsidies that involve partial funding of connections, work better. Demand side subsidies have better targeting properties and provide greater incentives for expanding coverage and sustaining services. Supply side subsidies, although easier to implement, have the disadvantages that they are difficult to target, and often undermine efficient service delivery, and raise costs above what they would otherwise be. While the proper design of the subsidy would improve its effectiveness in reaching the poor, the ultimate success of the subsidy schemes also requires setting up effective institutional structures, developing regulations that allow businesses to charge remunerative prices for energy services they provide, mechanisms to offset the tendency of politicians to divert subsidies to political interest groups, and the active involvement of community groups in the design of subsides. 28. To promote rural electrification, the following actions are needed: (a) develop community based micro-hydro systems; (b) commercialize the pico-hydro systems to replace and supplement the traditional water power systems; (c) establish and strengthen user groups; (d) launch awareness campaigns about the possible productive uses of electricity and the markets for the products produced; (e) assess barriers to private entry in rural electrification projects; and (f) create an enabling environment that promotes private sector involvement. Possible institutional means to achieve the above action plan could include the following: (i) setting-up a Rural Electrification Office with the capacity for providing technical assistance support for the development of grid and non-grid electrification projects; (ii) establishing rules for off- grid rural electrification including for possible subsidy schemes and for ensuring that the private sector can charge tariffs that allow them to operate a financially sustainable business; (iii) assessing the desirability of well targeted and conceived loan funds, with possible subsidies for capital costs for new connections; (iv) developing low cost off-grid extensions; and (v) coordinating donor support to maximize efforts to achieve rural electrification, especially off-grid electrification.  I. Introduction 1. Despite having an estimated hydropower generating potential of about 43,00 MW4 Nepal's current total installed generating capacity is only about 319 MW5 and its per-capita electricity consumption of about 42 kWh is amongst the lowest in the world. Only about 15 percent of the population have access to electricity. In rural areas where the bulk of the population resides, access is even lower (5 percent), partly as a result of a higher priority given to providing power to high-density urban areas. The quality of supply is poor; dry season generation capacity is inadequal:e; systems losses are high; and outages are frequent. Power trade with neighboring India is minimal, and Nepal has been a net importer of power from India over the past few years. Despite the desire for reform expressed by His Majesty's Government of Nepal (HMGN) and the initial measures being implemented, serious problems persist which impede HMGN's ability to respond to the sectors developmental objectives. 2. In this discussion paper we examine some of the key problems facing the development of Nepal's power sector, and propose options to address these problems. We ask why these main problems have arisen and to what extent they could be mitigated by reform. For example, there is not much that can be done about Nepal's geography and lack of indigenous fossil resources, which makes the cost of imported liquid fuel for thermal generation relatively expensive. But there is much that could 'be done to ensure that: * Nepal's hydro resources meet the needs of its urban and rural population in a least-cost way. * The roles of various public sector institutions are clear and non-conflicting. - There are in place regulatory and institutional frameworks that make it easier to mobilize private capital. - Power is not made even more expensive to the consumer due to high T&D losses characteristic of an inefficient institutional setup. * The structure of the main public-sector institution (NEA) operating in the power sector is such that it is creditworthy and enables, rather than prohibits, the realization of the long-term developmental goals of the sector in partnership with the private sector. * The expectations about the prospects for export and revenue realization are realistic, and efforts are made to realize these expectations. This paper reviews options in four critical areas that are at the core of Nepal's power sector problems, viz., the roles and responsibilities of public-sector institutions in the energy sector; instilutional structure of NEA; power trade with India; and rural access to electricity. 3. The paper does not claim to have answers to all of Nepal's power sector problems. It recognizes that results cannot be achieved overnight and many changes require long gestation periods and need to be implemented in the near term to be most effective, especially in areas that demand major capital investments. As the problems of the sector deepen, sector reform becomes increasingly difficult, underscoring the need to act without delay. The paper also recognizes that sustainable solutions come about only if the stakeholders themselves take ownership of the work. It is evident that on many issues it will take time to find the degree of consensus necessary to allow a finalization of the power sector development strategy, particularly given the on-going formulation of the water development strategy and the proposed revisions to the Hydropower Development Policy which now seems to be on the fast track. The new Hydropower Development Policy provides clear signals on the direction of power reforrn HMGN's wishes to take. The recommendations provided in the latest version (December 2000) of the Hydropolicy are consistent with the findings and recommendations of this report viz., Power Sector 4. The Nation's hydropower production capacity is estimated to be roughly 83,000 MW. Of which about 43,000 MW is considered economically and technically viable. 5. Installed capacity is estimated to have reached 378 MW in 2000, because of the coming on stream oi- Kimti Kola and Modi Kola during the second half in 2000 (Source: NEA's Corporate Development Plan, FY2000/01-FY2004/05, December 2000).  -2- Development Strategy (PSDS). Detailed comments on a previous version of the Hydropower Development Policy (June 2000) are recorded in Annex 1. 4. The objective of this paper, together with the three detailed background reports viz.: l) Institutional Restructuring of NEA, Mangesh Hoskote and Beatrice Arizu, April 2000; 2) Hydropower Exports from Nepal, prepared for The World Bank by Peter Meir, April 2000; and 3) Nepal: Power Sector Development Strategy, Rural Electrification Component, prepared for The World Bank by ENTEC AG, October 26, 1999 is to enumerate the main options; assess the advantages and disadvantages of each (bringing to bear the lessons of the relevant worldwide experience); and suggest a program of action in each area. Many of the proposed actions are required regardless of the final restructuring model chosen by HMGN: For example, across a very wide range of options for restructuring and ownership of NEA, its generation function needs to be placed in a separate entity. In preparing this report, we have taken into account comments made in the Technical Discussion meeting held in Katmandu on February 27-28, 2000 and a series of workshops held in Kathmandu over the period December 4-8, 2000. The Technical Discussions meeting and the workshops were attended by senior policy makers and a number of other key stakeholders. It is anticipated that the findings of this report will assist HMGN to formulate its own strategy for the development of the power sector. II. Overview of Nepal's Power Sector Supplies and Resource Base 5. Nepal has vast hydro resources, which represent a source of potential wealth. Commercially exploitable hydropower generating potential is estimated to be about 43,000 MW. Except for some lignite deposits, Nepal has no known oil, gas or coal deposits. All commercial fossil fuels (mainlv oil and coal) are either imported from India or from international markets routed through India. Fuel imports absorb over one-fourth of Nepal's foreign exchange earnings. 6. Despite the hydro potential, hydro electricity accounts for only one percent of total energy supplies. The bulk of Nepal's energy supplies (about 91 percent) comes from traditional sources, mainly from fuelwood (68 percent), agriculture waste (15 percent), and dung production by livestock (8 percent). Commercial sources, including hydro, account for the remaining nine percent (petroleum 7 percent, coal I percent, and hydro electricity 1 percent). 7. Nepal's domestic electricity supply system is small. Current total installed electric p ower generating capacity is dominated by hydropower, which constitutes 84 percent of installed capacity. The balance is composed of thermal installations using multifuels and diesel plants. 8. Hydropower facilities are mostly run-of-river, accounting for 71 percent of installed capacity. A system dominated by run-of-river is susceptible to high rates of spillage. Although firm estimates are not available, in some years about one-fourth of hydro production was lost due to spillage. While more storage plants could indeed reduce spillage, storage projects are usually relatively more expensive. Run- of-river (albeit with sufficient pondage to be used for daily peaking) represent the least-cost development plan of the NEA system, at-least until such time as the Nepalese system is interconnected with India. Currently, only one power station--the 92 MW Kulekhani--has seasonal storage capacity. The main load center is the central zone, which includes the Kathmandu Valley. The main transmission line is 132 6. With the addition of two new hydropower generating facilities during the second half of 2000, share of hydro has now jumped to an estimated over 86 percent.  -3- kilovolts (kV) and runs for approximately 1200 kilometers parallel to the Indian border from east of Nepal (Anarmani) to west of Nepal (Mahendranagar); major sub-stations are located in Hetuda, Syuchatar and Balaju. Demand and Prices 9. The main consumers of electricity are households and industries, accounting for 39 percent and 42 percent, respectively, of total power use in 1999. Although the growth rate in the demnand for power in industries has outpaced that of households over the past decade, these two sectors account for roughly 82 percent of total electricity demand. Commercial (7 percent), non-commercial (6 percent), water supply and irrigation (2 percent) and lighting (3 percent) account for the remaining 18 percent (Table 1, Chart 3). Electricity use is characterized by a load profile dominated by a large number of household connections and relatively few industry consumers. In 1998, the domestic sector accounted for 95 percent of customers while the industrial, and combined commercial and non-commercial consumers accounted for less then 2.5 percent and 1.8 percent, respectively. A high proportion of domestic load exhibits strong evening lighting load peaks and little baseload industrial load that could absorb off-peak run of river energy. Table 1: Electricity Sales by Consumer Category in Gigawatt Hour (1991-1999) Category 1991 1992 1993 1994 1995 1996 1997 1998* 1999** Domestic 261.39 275.24 259.83 275.05 301.61 328.73 355.1.1 378.77 415.24 Non-Commercial 46.23 46.68 47.60 47.14 53.22 53.46 57.99 60.22 64.49 Commercial 36.64 45.20 47.60 48.98 58.57 62.91 67.60 71.47 77.78 Industrial 206.88 246.37 273.75 303.99 328.31 358.67 376.74 413.73 437.14 Water Supply & 27.68 27.70 24.11 19.40 27.63 25.09 27.97 29.04 23.44 Irrigation Street Light 7.30 7.80 8.06 8.85 12.17 16.72 20.92 26.58 29.72 Temporary Supply 0.42 1.00 0.92 0.56 1.22 1.15 0.4 0.71 0.70 Transport 1.82 1.50 1.39 1.33 1.45 1.43 1.48 1.66 2.24 Temple 0.36 0.41 0.46 0.65 0.89 1.50 1.69 1.80 2.10 Total (Internal 588.76 651.94 663.24 705.99 785.10 849.68 910.38 984.01 1,052.88 Sales) Bulk Supply 80.64 85.41 46.13 50.51 39.47 87.01 100.21 67.41 60.00 Grand Totl * 669.40 737.35 709.37 756.5 824.58 936.69 1,010.60 1,051.42 1,112.88 Source: National Electricity Authority - A Year in Review FY1998199 Note: * Subject to final audit ** Provisional figures a. In 2000, sales are estimated to have increased to 1269 Gigawatt Hour ((Source: NEA's- Corporate Development Plan, FY2000/01-FY2004/05, December 2000).  -4- Chart 3: Electricity Demand 1991 VlterSL4iy& 1999 mItgacn St, [jjI 04%m 4.T7a Ch 4 \ Y// Datestic WM9r SLoy & IrTigGn a riet Lglt Oth <1% +j > 444